Contract Design Capabilities

In his thoughtful appraisal of Milgrom and Roberts (1992), Brian Loasby pointed out that the ability to transact and exchange is itself a capability, that firms may differ in terms of such capabilities, but that organizational economics routinely assume that firms have perfect transacting capabilities. This insight has been curiously neglected in the lenghty debate on the relations between transaction costs and capabilities. Former O&M guest blogger Dick Langlois is one of the few scholars who have embraced the insight, mainly from the capabilities side of the debate and casting it in terms of his notion of “dynamic transaction costs.”

A recent line of research initiated by Nick Argyres and Kyle Mayer addresses the issue more from the organizational economics, mainly TCE, side. Thus, Nick and Kyle’s excellent 2004 Organization Science paper, “Learning to Contract,” makes the empirically grounded point that changes in the structure of the contracts that govern a relationship may (for complex contracts in uncertain environments) reflect joint learning rather than the risks of specific assets.

In a paper published in the latest issue of the Academy of Management Review, “Contract Design as a Firm Capability: An Integration of Learning and Transaction Cost Perspectives,” they take a closer look at the capabilities that may underlie processes of learning to work together, including learning to contract. To do so they disaggregate capabilities to employee skills, specifically the skills of the focal firm’s managers, engineers and lawyers with respect to designing certain kinds of contrasct terms. Their addition to the efficient alignment principle of traditional TCE is to suggest that contracting capabilities should be aligned with contract term types: “…achieving superior exchange performance over time requires aligning the use of various contract terms to transaction attributes, and then developing and exploiting contract design capabilities to design those contract terms effectively” (p.1061) (they call this “dual alignment”).

Nick and Kyle put forward a series of propositions (i.e., the usual AMR routine) regarding which employees (managers, lawyers, engineers) will handle which contract terms (roles/responsibilities, decision/control rights, communication, contingency planning, dispute resolution), and they even give their reasoning a resource-based twist by arguing that contract design capability that are rooted in the skills of managers and engineers are more likely to be sources of competitive than those rooted in the skills of lawyers.

The Argyres and Mayer paper significantly advances the field by disaggregating contract design capabilities, linking them to occupational categories (one of the reasons why there is so little successful work that successfully integrates the capabilities view and TCE has to do with the aggregate nature of the former and the micro nature of the latter). It makes these kind of capabilities empirically researchable in a rather direct way.

One may (mildly) criticize a number of features of the paper. In particular, the learning emphasis of the earlier paper seems to have disappeared from the present (in spite of its title) in favor of a static efficient (dual) alignment principle. It would be interesting to confront the propositions on the allocation of the skills of managers, engineers, and lawyers to contract terms types with reality: Is it really the case that one can in actualy neatly perform such an allocation? I doubt it. Still, this is an important paper that deserves to be read, cited, and used.

Related

Meta-proposition: It’s always easier to describe learning empirically than it is to model it theoretically.

Meta-proof: I can often observe, after the fact, specific instances where actors adapt to particular past experiences.

I have great difficulty parameterizing in advance the sets of experiences actors might face and the set of potential adaptations they might consider. In addition, if I could parameterize those future experiences and adaptations, then so could the actors in the model, who could then replace inefficient after-the-fact adaptation with foresighted contingent plans and contracts. META QED.